August 28, 2011

One of the leading crude oil futures contracts–CME Group’s WTI–has been the subject of a drumbeat of criticism for months due to the divergence of WTI prices in Cushing from prices at the Gulf, and from the price of the other main oil benchmark–Brent. But whereas WTI’s problem is one of logistics that is in the process of being addressed, Brent’s issues are more fundamental ones related to adequate supply, and less amenable to correction.

Indeed, WTI’s “problem” is actually the kind an exchange would like to have. The divergence between WTI prices in the Midcontinent and waterborne crude prices reflects a surge of production in Canada and North Dakota. Pipelines are currently lacking to ship this crude to the Gulf of Mexico, and Midcon refineries are running close to full capacity, meaning that the additional supply is backing up in Cushing and depressing prices.

But the yawning gap between the Cushing price at prices at the Gulf is sending a signal that more transportation capacity is needed, and the market is responding with alacrity. If only the regulators were similarly speedy.

The main obstacles that the WTI contracts face are enviros and Coasean challenges. Environmentalists have been trying to put every regulatory roadblock possible in the way of one of the pipeline projects–TransCanada’s Keystone XL. This would bring oil produced from oilsands from Alberta through Oklahoma and on to Texas. The project cleared one roadblock last week, when the State Department (which has to approve due to the international nature of the pipeline) released an eight volume (!) study finding that the pipeline poses no significant environmental impacts. The pipeline’s opponents are vowing to redouble their efforts, and the issue is now wrapped up in presidential election year politics.

The Coasean challenge is that reversal of the Seaway pipeline currently flowing from the Gulf to the Midcontinent would cost one of the owners–ConocoPhillips–money by raising input costs for its Midcontinent refineries. Even though there are more than enough gains on the table to compensate CP for any losses arising from a rise in the price of Midcon crude, so far no one has been able to craft a deal whereby the winners (primarily Canadian and US producers) can make it worth CP’s while to agree to the reversal.

But these problems are all surmountable. WTI’s problems arise from the consequences of too much supply at the delivery point, which is a good problem for a contract to have. The price signals are leading to the kind of response that will eliminate the supply overhang, leaving the WTI contract with prices that are highly interconnected with those of seaborne crude, and with enough deliverable supply to mitigate the potential for squeezes and other technical disruptions.

Brent’s problems are more fundamental, because they arise from declining supply. Even as paper volumes continue to rise, physical volumes available for delivery are falling inexorably. The Brent complex had faced this problem before, and confronted it by adding Forties, Oseberg, and Ekofisk to the eligible stream. But BFOE production has declined from 1.6 mm bbl/d in 2006 to barely more than half that today. And the decline continues apace. This makes the contract vulnerable to squeezes of a kind that were chronic in the 1990s and early 2000s, and which spurred Platts to add the three other grades to the benchmark.

There are, moreover, few additional North Sea oil stream that can be added to the benchmark this time. So over the medium term Platts is considering adding other low sulphur crudes produced outside the North Sea to the contract.

The Brent problem is analogous to that faced by the Chicago Board of Trade grain and soybean contracts in the early-1990s. Volumes of corn, wheat, and soybeans shipped into Chicago and Toledo–the delivery points–were falling, though not due to declining production, but due to changing trade patterns. Deliverable supplies in Chicago and Toledo were not reliably sufficient to ensure the pricing integrity of the contract. The Ferruzzi soybean squeeze in July, 1989 brought matters to a head and forced a reluctant CBT to act.

The CBT’s initial response was to tinker with the contract, adding St. Louis as a delivery point at a modest premium to Chicago. Within a few short years, however, all delivery warehouses in Chicago proper had closed, and the exchange had to adopt a substantially different delivery mechanism (which I helped design–more on this below).

One approach available to Platts would be to create what I called an “economic par” contract in a report (subsequently a book–such a deal!) on the CBT contracts that I wrote in the aftermath of the Ferruzzi episode. In an economic par contract, differentials for delivery of different grades (or at different locations) are set approximately equal to the cash market differentials. For instance, if Brent was made the par grade, and another type of crude that typically sells for a $2 discount to Brent were made eligible for delivery against the contract, the deliverer would receive $2 less for delivering that grade than delivering Brent.

The advantages of this type of system are (a) it allows a dramatic expansion of deliverable supply, thereby easing technical/squeeze pressures on the contract, and (b) it can improve hedging effectiveness/reduce basis risk. In essence (as pointed out in the book), options pricing theory implies that with economic par terms the futures price becomes like a weighted average of the prices of the deliverable grades. This reduces the idiosyncratic component of futures price fluctuations, making the contract a better hedge for a variety of users. (Cash settlement based on a variety of crude streams would produce a similar outcome.) In the present instance, an economic par contract would be a poorer hedge for Brent cargoes, but a better hedge for other kinds of oil (e.g., Urals).

Since cash market differentials can vary over time, it is advisable to adjust the contract premia and discounts periodically. (The failure to do so with Treasury Bond futures in the 1990s caused some problems with the contract that were eventually fixed by the change from an 8 percent par coupon to a 6 percent.) Such changes can actually make the contract a better hedge by keeping the weights in the average more stable over time, thereby reducing the likelihood that the idiosyncratic risk of a particular deliverable grade exerts disproportionate influence on contract pricing.

Accomplishing such a substantial remake of a contract is, however, a difficult thing. Contract changes have different effects on different players, and each will try to lobby for changes that suit its interests. The case of Chicago grains is illustrative. As the decline in Chicago and Toledo continued apace, and the tinkering that followed the Ferruzzi squeeze proved inadequate, the CBT formed a committee to come up with a new contract design. The committee had representatives from virtually every affected party. Since the interests of these parties were so divergent, the process became rancorous and political, and the committee could not come to agreement on the kinds of changes that would have been necessary to fix the problem. Eventually, in late-1996 the CFTC said enough, and ordered the exchange to change the contract stat.

Realizing that the traditional committee method that gave everybody a voice would not meet the demands of an impatient CFTC, the exchange created a small task force (0f which I was an outside member) of more independent participants, and which pointedly excluded the big incumbent players (mainly Cargill, Continental, ADM, and The Andersons). This Grain Delivery Task Force came up with a radical new design (based on delivery via shipping receipts into barges on the Illinois River) in less than 6 months. The new design was approved by the membership and the CFTC over the following months.

Suffice it to say that the kind of consultative process that Platts envisions in revising the Brent contract will almost certainly bog down in the kind of rent seeking self-interested behavior that stymied fundamental changes in the CBT grain contracts. (In one of the early go ’rounds on this, in 199o–which spawned my report/book–one of the members of the committee set up to revise the contract was so outraged by my recommendations for bigger changes that we almost came to blows. The representatives from ADM and Cargill took him outside to cool down. I had similar experience, though more civil, during discussions of revising the canola contract in Winnipeg a few years later. Considering that the Brent market is so much bigger and the dollars at play in 2011 are so much bigger than two decades ago, the potential for pyrotechnics is all the greater now. )

Which means that those who are crowing about Brent today, and heaping scorn on WTI, will be begging for WTI’s problems in a few years. For by then, WTI’s issues will be fixed, and it will be sitting astride a robust flow of oil tightly interconnected with the nexus of world oil trading. But the Brent contract will be an inverted paper pyramid, resting on a thinner and thinner point of crude production. There will be gains from trade–large ones–from redesigning the contract, but the difficulties of negotiating an agreement among numerous big players will prove nigh on to impossible to surmount. Moreover, there will be no single regulator in a single jurisdiction that can bang heads together (for yes, that is needed sometimes) and cajole the parties toward agreement.

So Brent boosters, enjoy your laugh while it lasts. It won’t last long, and remember, he who laughs last laughs best.

You? Getting into blows with someone? Nahhhhhh….that could never happen.

But I do admit, secretly I think at some point you and some actual, PAID member of the anti-Russia Lobby™ are going to come to blows on some commodities related issue at some point, or maybe when you have the temerity to point out the Israelis just sold a crapload of U.S. taxpayer fund-designed arms to the Kremlins and the neocons all stubbornly instist that NEVER happened and say these are not the Israelis you were looking for, ala Obi Wan.

Or perhaps when the evil Kremlins start promoting a new gold and crude oil standard and as a Texan you decide that’s a swell idea. Then they send Cliff Kincaid to start digging through your garbage. And you wonder who is that weird bearded guy who asks this lifelong ornery libertarian leaning Texan why he’s suddenly fallen under the Commies’ spell?

There are so many funny scenarios for your ornery cuss tendencies to run smack dab into your pro-interventionism/foreign meddling Republicanism that it’s hilarious!

But as I say, better to make heads explode in Washington D.C. ala Darth Cheney than bomb the Roki Tunnel and make the world explode in WWIII!

Interesting post. Retired now, I spent my career as a crude trader for different oil companies, started before there was a contract and traded the WTI contract since its inception. Naturally I have opinions about this, essentially I agree with you that the WTI contract will prevail, unless the ICE comes up with some better version of the Brent contract. I would hate to be squeezed into delivering Brent, not enough to go around.

As to an economic par contract, first, the trend is towards Argus, away from Platts as a reporting agency and second, I THINK there remains in the industry a bias favoring a contract that would allow taking/making delivery.

I passed this along to a number of friends, many of whom are still active traders, so you might get a comment out of them.

[…] WTI priced crude. As numerous others have noted (see Craig Pirrong’s excellent post titled, A Tale of Two Contracts), in due time, as the North American crude oil transportation capacity is expanded (which will […]

[…] priced crude. As numerous anothers have noted (see Craig Pirrong’s excellent post titled, A Tale of Two Contracts), in due time, as the North American crude oil transportation capacity is expanded (which will […]

[…] priced crude. As numerous anothers have noted (see Craig Pirrong’s excellent post titled, A Tale of Two Contracts), in due time, as the North American crude oil transportation capacity is expanded (which will […]